A deferred payment results when the seller delivers goods and services, but then time passes before the customer pays for them. A "fly now, pay later" plan is an example of this situation, as are the so-called "0% financing" plans that some auto dealers use as customer incentives.
By contrast, the prepayment situation occurs when a buyer pays first and then a significant time passes before the seller delivers delivery of goods and services. Tenants typically pay floor space rental fees, for instance, at or before each occupancy period. Insurance companies typically require premium payment before the coverage period starts. Rental expense and insurance premium payments in such cases are thus prepayment situations for the buyer.
Explaining Deferred Payment and Prepayment in Context
Sections below further define and explain deferred payment and prepayment in context with related terms from accrual accounting, emphasizing two themes:
- First, defining accrual accounting terms involved when sales actions include transactions occurring at different times: Deferred Payment, Accrued Expense, Accrued Revenue, Deferred Expense, and Unearned Revenue.
- Second, explaining how a sale with delivery of goods and services at one time, and payment at another time, creates temporary "Deferred" and "Accrued" account balances.
- What are deferred payment and prepayment?
- How are deferred payment and prepayment related to other accounting concepts?
- Prepayment: Payment precedes delivery of goods or services.
- Deferred payment: Delivery of goods or services precedes payment.
- Does the deferred payment and prepayment concept exist in cash basis accounting?
- For an introduction to basic accrual concepts, see Accrual Accounting.
- See Deferred Expense for sample transactions and explanation of the deferred expenses concept.
- Unearned Revenue explains the concepts unearned revenue and deferred revenue.
- See Matching Concept for more on the role of deferred payment in accrual accounting.
Prepayment occurs when the buyer pays first before the seller delivers goods or services. During the time between these two events, both seller and buyer keep the uncompleted sales event on the books as follows:
Prepayment From the Seller's Viewpoint
- Firstly, the seller recognizes unearned revenues (or deferred revenues) as revenues received for goods and services that the seller has not yet delivered. At the same time, the seller records unearned revenues as liabilities.
- Secondly, when the seller delivers goods or services, the seller replaces the unearned revenue liability by declaring the revenues, now, as earned revenues.
Prepayment From the Buyer's Viewpoint
- The buyer recognizes deferred expenses (or prepaid expenses or deferred charges), when paying for services or goods before delivery. An inventory of postage stamps, bought but not yet used, is a prepaid expense. Or, when a firm pays taxes before the due date, the firm creates a prepaid expense. Prepaid expenses appear on the Balance sheet under Current assets.
- When the seller delivers goods or services, the buyer replaces the prepaid expense asset with an ordinary expense transaction.
Deferred payment occurs when the seller delivers goods or services, first, and the buyer pays later. During the time between these two events, both seller and buyer keep the uncompleted sales event on the books as follows:
Deferred Payment From the Seller's Viewpoint
- The seller records accrued revenues (accrued assets, or unrealized revenues). These are revenues the seller earns for delivery of goods and services before the customer pays. The seller may post these revenues in an asset account, such as accounts receivable.
- When the buyer pays, the seller credits (reduces) its Accounts receivable account and, debits (increases) another asset account, Cash, at the same time.
Deferred Payment From the Buyer's Viewpoint:
- The buyer records and posts the sale amount to a liability account, such as accrued expenses. This amount is for goods and services the buyer has received but not yet paid for. Or, when a firm owes employees salaries or wages for work completed, the employer has an accrued expense. And, interest due for a bank loan can be an accrued expense. In all cases, these accrued expenses first enter the journal as liabilities.
- When the buyer pays, the buyer debits (reduces) the liability account and at the same time credits (reduces) an asset account, such as cash.
For any company on a cash basis accounting system, however, the bookkeeping practice is much simpler. In cash basis accounting:
- Expenses are recognized when cash is paid
- Revenues are recognized when cash is received.
Deferred expenses (prepaid expenses, or deferred charges) along with the other prepayment and deferred payment situations described above, are accrual accounting concepts. These concepts do not exist in cash basis accounting.